“Too big to fail” was the verdict in the U.S. Treasury decision to backstop mortgage lenders Fannie Mae and Freddie Mac. But is the taxpayer risk of moral hazard still as big as ever?

Investors trashed shares of these government-sponsored enterprises last week, knocking them down almost 50 percent on a wave of bankruptcy rumors. Former St. Louis Fed president Bill Poole argued that technically, the two are already in bankruptcy, while fears spread they couldn’t even raise overnight money to finance their operations.

So Treasury secretary Paulson stepped in. His full-throated-support plan raises Fannie and Freddie’s line of credit from $2.25 billion to $300 billion, and leaves the door open for the Treasury to buy stock in the banks. The Federal Reserve, meanwhile, would make its discount lending window available to the pair if necessary.

For decades, Fannie and Freddie sold pools of mortgage-backed securities in the bond market and raised cash for their own accounts under the previously untested assumption that someday the implicit guarantee of the full faith and credit of the U.S. government would become explicit. That explicit promise has now become the new reality.

Fannie and Freddie paper is owned by institutions and investors worldwide. And yes, if there had been a run on these banks, the global financial system would have titled precariously toward calamity. So the bailout was wise, at least in the short run.

But what happens in the longer run?

Mr. Paulson’s dramatic Sunday-evening announcement raises as many questions as it answers. Most important, will a new regulatory plan expected to be passed swiftly by Congress allow the two housing-finance giants to continue on their merry way? Or will there be serious changes in their conduct?

Here’s the issue: The main mission of Fannie and Freddie is to provide liquidity into the mortgage markets by purchasing loans made by local lenders and repackaging them into bond-market security pools that are sold to investors with the U.S. government’s stamp of approval. You might call this the good-cop function.

But then there’s the bad-cop function: Fannie and Freddie purchased some of these mortgage pools for their own portfolios, essentially setting up a high-risk internal hedge fund. It was the sinking credit quality of this hedge fund that drove last week’s shareholder run. Think sub-prime mortgages and other shaky and exotic loans. Continued...